Factors Influencing Interest Rate Risks | CFA Level I Fixed Income
Welcome back to our final lesson on fixed income risks and returns! Today, we’ll discuss the factors that affect a bond’s interest rate risk. So, let’s jump right in!
Properties Affecting Interest Rate Risk
Three main properties determine a bond’s interest rate risk:
These factors impact the Macaulay duration, which is a measure of interest rate risk. Keep in mind that these principles also apply to other duration measures.
Time to Maturity
- Shorter time to maturity means lower Macaulay duration
- Longer time to maturity means higher Macaulay duration
However, this relationship is not linear and has an upper limit.
Perpetual bonds have no maturity and an interesting Macaulay duration. The relationship between time to maturity and Macaulay duration changes when bonds are purchased at a discount, following a curve that first increases, then decreases over a range of long maturities.
Interest Rate Risk and Yield Volatility
Investors are concerned with not only the sensitivity of a bond’s price to changes in yield but also the volatility of the bond’s yield. The relationship between yield volatility and time to maturity is referred to as the term structure of yield volatility.
Duration and convexity calculations often assume a parallel shift in the yield curve, but this is not always the case in practice. For instance, central bank policies can impact the yield curve, causing it to steepen or flatten.
In conclusion, the Macaulay and modified duration of a fixed-rate bond depend primarily on its time-to-maturity, coupon rate, and yield-to-maturity. Longer time-to-maturity usually leads to higher duration, while a higher coupon rate or a higher yield-to-maturity reduces the duration.